Our latest market views

Dec 14, 2018

By BlackRock Investment Institute

We identify three new market themes and update our asset views for 2019. We see growth in the global economy and corporate earnings slowing, and expect the Federal Reserve to become more data dependent in increasing rates. For investors, greater uncertainty calls for balancing risk and reward.

We expect global growth to slow next year, and see U.S. growth stabilizing at a much higher level than other regions, even as the effects of 2018’s fiscal stimulus fade. Markets are vulnerable to fears that a downturn is near, even as we see the actual risk of a U.S. recession as low in 2019. Global earnings growth is also set to moderate in 2019, tracking the more subdued growth outlook.

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We’re talking about a slowdown in the pace of economic growth, not necessarily an end to the expansion.”

- Kate Moore, Chief Equity Strategist, BlackRock Investment Institute

Wider range of growth outcomes

View transcript

Kate Moore :

The first theme of our 2019 outlook is growth slowdown. But let’s be clear, we’re talking about a slowdown in the pace of economic growth, not necessarily an end to the expansion. In fact, we see the global economic expansion continuing not just through 2019, but into 2020. This is also important because in the beginning of 2018, we were really featuring a view of sustained and synchronized expansion. But in the year ahead, we expect the growth rate of different regions and countries to vary meaningfully. This will lead to investment opportunities and significant implications for risk assets across all different regions. We also talk about a slowdown in the pace of earnings growth in 2019, and just with economic growth, we would also want to point out that this is a slowdown in the pace but not actually an end to what we expect to be a sustained earnings expansion over the years ahead. So what are the investment implications? In a world where growth is slowing down but still expanding, and where earnings growth is going to be lower than it was in 2018, we think investors need to be much more differentiated and tactical in their portfolios than they were earlier in the cycle. This leads to opportunities in different regions and sectors. Our two favorite regions based on both economic growth and earnings growth are the US and emerging markets led by China. We think both have adjusted to changes in policy over the course of the year, and are well-positioned to outperform over the year ahead.

We see the process of tighter financial conditions pushing yields up (and valuations down) set to ease in 2019. Why? U.S. rates are en route to neutral — the level at which monetary policy neither stimulates nor restricts growth.We estimate the current neutral rate at around 3.5%, right in the middle of the 2.5%-to-3.5% long-term range identified by the Fed. Yet we expect the Fed to pause its quarterly pace of hikes amid slowing growth and inflation in 2019.

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Now by our gauge, we do see financial conditions tighter, but they’re still relatively loose.”

Our second theme for the year ahead outlook is nearing neutral. It is true that the Federal Reserve is nearing its neutral rate that is a rate that neither stimulates nor restricts economic growth. But by our estimates, we still believe the Federal Reserve is well below the level of the neutral rate in the economy. It’s also true though that financial conditions are tightening. We have to understand the Federal Reserve has been raising interest rates since 2015, as well as continuing to normalizing their balance sheets. Now by our gauge, we do see financial conditions tighter, but we also say they’re still relatively loose. Now across the oceans, we still see the European Central Bank, as well as the Bank of Japan, still being very far off form fully normalizing monetary policy.

Increasing uncertainty – primarily about the impact of rising trade conflicts – points to the need for quality assets in portfolios. But building more resilient portfolios is about more than just dialing down risk, as overly defensive positioning can undermine investors’ long-term goals. We advocate exposures to government bonds as a portfolio buffer, flanked by high-conviction allocations in areas that offer attractive compensation for the risk.

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It's about a barbell approach as we look into 2019 to mitigate some of the uncertainty that we think about for portfolios.”

So our third theme we’ve labeled Balancing Risk and Reward. In 2018, what we saw was that uncertainty explained a greater portion of risk asset returns. So what should we do to mitigate that uncertainty in portfolios? One of the things we thought about at BlackRock is advising our clients to be building resilient portfolios. But building resilient portfolios is not just about dialing risk down. Because having too defensive of a position in your portfolio can actually offset some of your strategic goals. What we advocate is a barbell approach. On one end, core exposures to defensive assets such as short-term U.S. treasuries, which are attractive given the level of yield, as well as quality equities and/or the quality factor. On the other end of that barbell approach, we have to think about risk assets that should benefit should we see a reduction of uncertainty as well as a reduction in trade tensions, i.e., these assets that basically offer attractive risk premia given the decline that we’ve seen in 2018. So it’s about a barbell approach as we look into 2019 to mitigate some of the uncertainty that we think about for portfolios.

Rising recession fears

This cycle has been a long and shallow one – and still has some room to run, in our view. But how far? Our analysis suggests the one-year forward probability of a U.S. recession is still relatively low, consistent with our base case for ongoing economic expansion in 2019. Yet the odds are set to rise steadily thereafter, with a cumulative probability of more than 50% that recession strikes by the end of 2021. See the Recession watch chart.

Shifting geopolitics

Trade frictions remain elevated, but look more priced in by markets than a year ago. It’s Europe that has us worried. We expect no immediate flare-ups in the region, but believe investors may be underappreciating medium-term threats to European unity. See the BlackRock geopolitical risk dashboard for our analysis of market attention to our top-10 geopolitical risks. Selected European assets, such as Italy equities and European financials, have suffered heavy losses in the past when European fragmentation risks flared up. See the Geopolitical sting chart.

Fixed income

Rising rates have made U.S. shorter-term bonds an attractive source of income again. Two-year Treasuries now offer around 90% of the 10-year yield with only one-fifth of the duration risk. The picture looks similar in credit. See the Short beats long chart. Yet we are warming up to longer-term debt as a portfolio buffer against recession worries and a potential source of capital gains should the yield curve invert. Overall, higher yields and diversification benefits make us more positive on U.S. government bonds. We prefer to take risk in equities over credit.

Equities

Quality is key as the cycle matures. Our markers for quality include strength in free cash flow, growth and balance sheets. One sector where this is prevalent: health care. The sector also shows low sensitivity to global growth, which historically has provided resilience in late cycle. See the Seeking healthy fundamentals chart. Our positive view is further supported by favorable demographic and innovation trends, and a strong earnings outlook among defensive sectors.

Asset class views

Views from a U.S. dollar perspective over a three-month horizon

Asset Class

View

Comments

Equities

U.S.

Solid corporate earnings and strong economic growth underpin our positive view. We have a growing preference for quality companies with strong balance sheets as the 2019 macro and earnings outlooks become more uncertain. Health care is among our favored sectors.

We see a weaker yen, solid corporate fundamentals and cheap valuations as supportive, but await a clear catalyst to propel sustained outperformance. Other positives include shareholder-friendly corporate behavior, central bank stock buying and political stability.

EM

Attractive valuations and a backdrop of economic reforms and robust earnings growth support the case for EM stocks. We view financial contagion risks as low. Uncertainty around trade is likely to persist, though much has been priced in. We see the greatest opportunities in EM Asia.

Asia ex Japan

The economic backdrop is encouraging, with near-term resilience in China and solid corporate earnings. We like selected Southeast Asian markets but recognize a worse-than-expected Chinese slowdown or disruptions in global trade would pose risks to the entire region.

Fixed Income

U.S. government bonds

Higher yields and a flatter curve after a series of Fed rate increases make short-to-medium term bonds a more attractive source of income. Longer maturities are also gaining appeal as an offset to equity risk, particularly as the Fed gets closer to neutral and upward rate pressure is more limited. We see reasonable value in mortgages. Inflation-linked debt has cheapened, but we see no obvious catalyst for outperformance.

U.S. municipals

Solid demand for munis as a tax shelter and expectations for muted issuance should support the asset class. We prefer a long duration stance, expressed via a barbell strategy focused on two- and 20-year maturities.

U.S. credit

Solid fundamentals support credit markets, but late-cycle economic concerns pose a risk to valuations. We favor an up-in-quality stance with a preference for investment grade credit. We hold a balanced view between high yield bonds and loans.

European sovereigns

Yields are relatively unattractive and vulnerable to any growth uptick. Rising rate differentials have made European sovereigns more appealing for global investors with currency hedges. Italian spreads reflect quite a bit of risk.

European credit

Valuations are attractive, particularly on a hedged basis for U.S. dollar investors. We see opportunities in industrials but are cautious on other cyclical sectors. We favor senior financial debt that would stand to benefit from any new ECB support, over subordinated financials. We prefer European over UK credit on Brexit risks. Political uncertainty is a concern.

EM debt

We prefer hard-currency over local-currency debt and developed market corporate bonds. Slowing supply and broadly strong EM fundamentals add to the relative appeal of hard-currency EM debt. Trade conflicts and a tightening of global financial conditions call for a selective approach.

Asia fixed income

Stable fundamentals, cheapening valuations and slowing issuance are supportive. China’s representation in the region’s bond universe is rising. Higher-quality growth and a focus on financial sector reform are long-term positives, but a sharp China growth slowdown would be a challenge.

Other

Commodities and currencies

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A reversal of recent oversupply is likely to underpin oil prices. Any relaxation in trade tensions could signal upside to industrial metal prices. We are neutral on the U.S. dollar. It maintains “safe-haven” appeal but gains could be limited by a high valuation and a narrowing growth gap with the rest of the world.

Overweight Neutral Underweight

* Given the breadth of this category, we do not offer a consolidated view.

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